Nicole Seaman

Director of FRM Operations
Staff member
Learning objectives: Identify reasons for the failures of hedge funds in the past. Explain elements of the due diligence process used to assess investment managers. Identify themes and questions investors can consider when evaluating a hedge fund manager. Describe criteria that can be evaluated in assessing a hedge fund’s risk management process. Explain how due diligence can be performed on a hedge fund’s operational environment. Explain how a hedge fund’s business model risk and its fraud risk can be assessed. Describe elements that can be included as part of a due diligence questionnaire


21.14.1. You work for the Private Client division of an international bank. The bank's Private Client Advisors work with high net worth (NNW) individuals and families. Your boss has tasked you to perform due diligence on a roster of hedge funds; the funds that survive your due diligence will become candidates for presentation (and recommendation) to suitable customers of the bank who will become investors in the fund(s).

Your boss says that your due diligence should include a careful screen for fraud risk on behalf of the investors. In the case of your due diligence, which of the following is the most important ingredient?

a. Diligent use of a comprehensive checklist
b. Strong pre-existing personal relationships among the fund's managers and all related parties
c. Guarantees by the fund of exceptional performance (e.g., >30% per annum) with little or no risk
d. The investors' membership in an affinity group, preferably a religious group due to high correlation with ethics

21.14.2. Sally represents an investor who likes the strategy and style of a new, entrepreneurial start-up hedge fund. At her client's request, she is going to conduct due diligence. According to Kevin Mirabile (author of the hedge fund due diligence reading), as Sally conducts her diligence of the hedge fund on behalf of the investor, which of the following is the most important principle or ingredient?

a. She should observe strong evidence that the fund has eliminated business model risk via the SEC's Zeta Sigma AIML filter
b. She should confirm that the CEO is exceptionally good at all three top-level skills sets: investment, operational, and business
c. She should follow all the steps in the process but with flexibility as due diligence is also an art and each fund is unique with its own strategy
d. She should clarify that the fund's incentives are actual equity ownership grants rather than phantom equity and that they are granted throughout the organization to all full-time employees.

21.14.3. According to Kevin Mirabile (author of the hedge fund due diligence reading), in regard to the due diligence process which of the following statements is TRUE?

a. Risk disclosures should be limited and broad because this suggests consistency with the peer group
b. There are two (almost) equally important evaluations in the due diligence process: of the investment process; and of the operations and business model.
c. Because future returns cannot be known or expected, the due diligence process should overweight infrastructure (i.e, operational) and business model risks, but evaluation of the investment process should be deferred at least three (preferably five) ears until true, realized (aka, actual) returns can be evaluated
d. The best managers tend to be selective and therefore the potential investor should be careful not to ask too many questions because this may jeopardize participation in great opportunities

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