Hedge Fund Investing Chapter 11 Part 2: Due Diligence - Risk and Fraud

Part 1 covered how to prepare for due diligence and evaluate a fund’s investment process. Now comes the hard stuff. Risk management, operations, the business model, and the part nobody wants to think about: fraud.

Risk Management Process

Risk management used to be simple. The portfolio manager managed risk. Period. Now the industry is moving toward separating risk taking from risk measurement. Many funds have dedicated risk managers who report to the CEO or CIO independently from the traders. Some firms hire outside risk service providers to report directly to investors.

This separation matters. When the person who takes risk also measures it, you get blind spots.

How Is Risk Measured?

First, understand what risks the strategy exposes you to. An equity fund has beta risk. A credit arbitrage fund has spread risk. Global macro has inflation, interest rate, and currency risk. Event-driven funds have catalyst risk. Each strategy has its own set of risks, and your questions need to be specific.

Then ask about the process. Written policies? Risk committee? Do traders and back office staff actually participate in risk management, or is it a checkbox exercise?

Watch out for technology mismatches. Traders sometimes use different systems with different inputs than what the firm reports to investors. That disconnect can lead to nasty surprises.

How Are Securities Valued?

This is a big one. What percentage of the fund is valued using exchange prices versus model prices or broker quotes? Does the administrator handle valuation, or does the manager control it? Who can override prices?

If the manager controls valuation of hard-to-price assets, that is a red flag. Independent valuation by the administrator is the standard you should expect.

Leverage and Liquidity

Understand current and historical leverage, its sources, and portfolio liquidity. A convertible bond fund and an equity fund might both be “hedge funds” but operate with completely different leverage profiles.

Key question: does portfolio liquidity match what investors are offered? If the fund holds illiquid assets but allows monthly redemptions, there is a structural problem waiting to happen.

Tail Risk and Fund Terms

Some strategies have tail risk. Returns look smooth until one day everything blows up. Check the fund’s skewness and kurtosis yourself. If the manager says tail risk does not exist in their strategy, that tells you something.

Also check if the terms make sense. A long-only manager charging 2 and 20? Red flag. A liquid equity fund with a one-year lockup? Red flag. Compare to peers.

Fund Operating Environment

Operational due diligence is about making sure the fund’s back office can actually support the investment process. You are checking for risks of loss from settlement failures, misappropriation of assets, or breakdowns in the confirmation and reconciliation process.

Internal Controls

Start with the people. Does the CEO support a culture of control and compliance? Are the operations, accounting, and compliance people actually qualified? It is not unusual to do background checks on the COO and CFO, not just the portfolio managers.

Then check the written procedures for trading, derivatives, and cash handling. Some funds hire outside auditors to evaluate controls and issue formal opinions. Does the firm have a real compliance function with a code of ethics and employee trading restrictions? Or is it just a person with a title?

Counterparty Risk

After Lehman Brothers, MF Global, and Refco all went bankrupt, hedge funds that had cash with them lost money. Sometimes they never got it back. Funds need to diversify counterparty risk and monitor dealer health daily.

Documents and Disclosures

Read all the fund documents. The offering memo, subscription agreement, LP agreement, Form ADV, and website should all say the same thing. They often do not.

Check if the law firm that drafted the documents still works with the fund. Managers have changed documents without the law firm’s knowledge. Pay special attention to the conflicts of interest section. Vague language like “certain principals may maintain relationships with certain counterparties” can mean anything from harmless arrangements to the manager taking personal rebates from the prime broker.

Financial Statements

Start with the auditor’s opinion. It should be “unqualified,” meaning no material concerns. Then check if the balance sheet makes sense. An equity fund claiming low leverage should not have rising interest expenses. A buy-and-hold fund should show unrealized gains, not constant realized gains.

Recalculate the fees. They should match the offering documents. Never incentive fees in loss years. And check whether the general partner is still investing in the fund. GP pulling money out is a major red flag.

Business Model Risk

This section of the book really surprised me. You think of hedge funds as investment vehicles, but they are also businesses. And businesses fail for business reasons.

Before 2008, barriers to entry were low. Capital was everywhere. Markets went up. A mediocre manager could still make money. Not anymore. Today, more funds close than launch in some years.

The Green Zone Model

The book references a study by Merlin Securities that categorizes fund business models into three zones:

• Red zone - the fund depends on outsized performance to cover its operating costs. If returns are bad, the business fails.
• Yellow zone - needs minimal performance to survive. Some cushion but not much.
• Green zone - can sustain itself even when performance is low, zero, or negative. These funds have the highest survival rates.

Simple math. Funds relying on performance fees (20% of profits) have fragile business models. One bad year and they cannot pay the bills. Funds where management fees (2% of AUM) cover operating costs are much more stable.

Questions To Ask

The book lists ten questions about business model risk. My favorites:

• How many months of cash do you have in the bank?
• Do you have a multiyear budget? (Many do not.)
• What is the break-even AUM level?
• What is the succession plan if the founder gets hit by a bus?

Basic questions for any business. But many hedge fund managers have never had to answer them. They came from trading desks. Running a company with payroll and compliance costs is a different skill.

Fraud Risk

The FBI lists hedge fund fraud as a type of white-collar crime. That should tell you something about the industry’s history.

Fraud indicators from the FBI:

• Fund trades through an affiliated broker-dealer (no independence)
• Investors complain about liquidity
• There is litigation alleging fraud
• Performance claims are unusually strong
• High percentage of illiquid or manager-priced investments
• Related parties involved in valuation
• Managers trading the same securities as the fund in their personal accounts
• Aggressive shorting combined with spreading rumors about companies

Here is what gets me. In most major hedge fund frauds, the information was publicly available. Lawsuits, regulatory filings, complaints. People just did not look. Or they looked and did not want to believe what they found. The returns were too good. The name was too big.

Due diligence is not glamorous work. Reading documents, making phone calls, checking databases, asking uncomfortable questions. But it is the difference between investing in a legitimate fund and handing your money to a fraud.

The book ends by reminding us that due diligence is as much art as science. Use checklists so nothing gets missed. But also ask open-ended questions that reveal the firm’s culture. Every fund is unique. The process should be thorough, always.

Previous: Chapter 11 Part 1 | Next: Chapter 12 Part 1

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