Due Diligence: A Definition
Due diligence is the process of identifying the best hedge fund manager for your investment goals and thereafter continually reevaluating them at regular intervals to ensure that they continue to meet your requirements. In doing so, it looks across the entire gamut of the fund—its investment strategy, performance, personnel, legal structure, risk management, documentation, operational infrastructure, service providers, counterparties, and client base. In essence, it is a proactive risk management approach that successfully balances the twin goals of any investment: generating superior returns while minimizing risk.
Looking at past performance alone is often meaningless in the hedge fund world. Performance tells you nothing about the underlying strategy, its advantages and disadvantages, management’s skill, the use of leverage, the impact of different market conditions, and so on. Further, selection bias means that most investors will naturally gravitate toward those strategies and funds that have performed well in the past. Any successful hedge fund strategy will seek in principle to deliver targeted returns within the confines of some defined risk constraints. Yet, while quantitative measures such as volatility capture the riskiness of performance, it does not tell investors how robust the fund’s underlying risk management is and how it may react to leaner times in the future.
In contrast, careful due diligence provides a valuable insight into the quality of the fund’s strategy, personnel, systems, and, vitally, their risk management. Investors know what to expect in good and bad times, and are able to approach their investment in a rational manner without worrying over every inevitable jitter.
The questions you ask are driven ultimately by your investment goals and the constraints on your balance sheet, such as your investment horizon and the need to maintain an optimal liquidity profile commensurate with your cash flow requirements. While no two investors are likely to have the same set of questions, there are fundamental areas that any proper due diligence process needs to cover.