Conducting due diligence on Hedge Funds and other non-traditional investments costs much less than the damages associated with potential fraud or misrepresentation, a report from SwissAnalytics concluded.

One area of focus should be in the area of valuations. “It is absolutely crucial to determine who provides the values for individual positions,” the report noted, with specific highlight on basis of how such values are determined. In particular, it is not uncommon that values of underlying positions, particularly less liquid instruments used by certain macro hedge funds, end up being inflated. This has resulted in several situations where the corresponding write-offs were 20% or more.

Due diligence concern: Signature rights

Another area of due diligence concern is a little known area of signature rights. Lacking adequate safeguards regarding who can sign to transfer money in and out of the fund is a sure invitation for fraud and opens the door to assets are being stolen. “In such cases the resulting damages are often devastating and the corresponding hits on the NAV are often in the 50% to 100% range,” the report said.

An issue that came up during the MF Global episode. and one that was also laid bare during the Lehman collapse. was the extent to which assets may assets can be re-hypothecated. In the case of MF Global, customers ultimately had all their inappropriately transferred assets returned. A key due diligence question to ask is to what degree are fund truly segregated.  Addressing this issue up front is critical. Even if such assets may ultimately be recovered, as was the case in MF Global, the legal proceedings could render even liquid long-short strategies suddenly illiquid, the report noted.

Successful due diligence

Successful due diligence is not just about identifying issues, it is about interpreting what those issues mean. On the surface a potential due diligence issue might not appear significant to an untrained eye. For instance, not having appropriate signature rights might seem like an oversight. But in fact, having such clear paths to responsibility can in fact deter fraud. If those in fund management responsible for asset transfers are clearly identified as being responsible in fund documents, it makes a significant statement. In like fashion, not having what might seem like a minor detail in place also makes a big statement.

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