Has the process of due diligence changed? Are investors taking this more seriously and is it having any impact on hedge funds or funds of hedge funds and their operations or structure?

Until the Madoff affair, many thought the cursory due diligence process was enough to safeguard investment. No longer. While too many are still not conducting thorough due diligence, it has become a top priority for the majority of investors. The process now encompasses not only the fund itself but also its service providers – a consequence of the demise of Lehman Brothers, which also caught out a lot of people who had not taken counterparty risk seriously.

“The Madoff affair highlights that conducting thorough due diligence prior to making an investment is a central preliminary to the investment process rather than ancillary to it,” notes John Langan at Withers.

He says clients are facing risks from many directions, including legal liability, risk of investment loss or devaluation, compliance failure and taxation. “The mitigation and balancing of risk in all its forms is of paramount importance for many clients,” Langan says. “All investors should include a thorough due diligence process in their risk management procedures.”

Not surprisingly, points out Langan, most investors now take due diligence “extremely seriously”.  While in the past many investors primarily focused on analysing the performance of funds with the due diligence process taking a back seat in terms of importance, the frauds and numerous bank problems have highlighted the need for a more rigorous process. 

Simon Thomas at Akin Gump says his firm has noticed investors still in the market are taking due diligence must more seriously. “Investors now have a much greater understanding of counterparty risk,” he says. “They also place greater emphasis on their likely exit from the fund, for example, seeking an understanding on the operation of the fund’s gate and any likely suspension of redemption,” concludes Thomas.

Simon Firth at Kaye Scholer believes the process has become more standardised with Iosco principles, Hedge Fund Standard Board standards, the Alternative Investment Management Association (AIMA) recommended practices and the US President’s Working Group all vying for attention. “Following the financial crisis, investors are focusing more on fund documentation including understanding prime brokerage documentation and legal risk,” notes Firth.

Nora Bullock and Simon Atiyah at Lovells also believe due diligence and the decision-making process is becoming more rigorous and more formal. They say funds have to devote more time and costs to investors’ due diligence queries because of anti-money laundering requirements, among other demands. According to Bullock and Atiyah, due diligence is no longer just a paper form-filling exercise. All service providers are caught in the process. It is common now for the lawyers of investors to review fund documentation and produce side letters in a way that historically has been done in the private equity rather than the hedge fund world, note the pair.

Brian McDermott and Siobhán Moloney at A&L Goodbody agree that post-Madoff there is more focus on due diligence, particularly for funds of hedge funds. They say there is more intense scrutiny of funds, their service providers and counterparties, including their lawyers and auditors, as well as the jurisdiction in which they are regulated. McDermott and Moloney think this attention to detail is likely to benefit top-tier providers in each area as well as jurisdictions that are perceived to offer a more robust regulatory environment.

“The current volatility in the market, combined with recent scandals, has brought operational practices into the limelight and caused investors to begin conducting formal due diligence assessments of administration operations prior to placing assets with funds,” says Joey Garcia at Isolas in Gibraltar.

Omar Zerafa at Aequitas Legal in Malta believes due diligence is continuously increasing. “Investors are seeking more transparency in the hedge fund investment techniques and they are demanding more open communications on hedge fund strategies and frequent reports. This has a great impact on the functioning of the fund,” he notes.

The due diligence process, says Ingrid Pierce at Walkers in the Cayman Islands, has changed and become much more focused as a practical matter. “Funds, counsel and service providers are increasingly being asked a number of different questions and are requested to verify certain facts,” she says.

“Responding to these enquiries can be time consuming, particularly if there are multiple requests or follow-up questions. Directors are routinely being asked to provide detailed information (including supporting documents) about themselves and those who control the fund,” notes Pierce.

Tania Dons and Richard Finlay at Conyers Dill & Pearman in Cayman say investors are undertaking much more due diligence and taking a lot more care before investing in funds. They say they have seen a dramatic increase in the number of investors coming to the firm to review fund documents and provide legal advice prior to investment. According to Dons and Finlay, managers are increasingly being requested to provide detailed information, to meet with investors and to introduce them to key staff. The obvious impact on funds is an increase in costs, they conclude.

Robert Briant in the British Virgin Islands office agrees that the due diligence carried out by investors has changed significantly. “As a result of issues that were uncovered as a result of the recession, investors are being more careful in connection with their investments and in particular are giving greater scrutiny to hedge funds,” he says. “This greater scrutiny is not having any particular negative impact on properly structured hedge funds, other than the time required to demonstrate to the investors that the hedge fund is properly structured.”

At Conyers’ Bermuda office Dawn Griffiths tells much the same story. “Investors are much more attuned to the need for a disciplined approach to their due diligence. We have already seen much more time and effort being applied to this process by prospective investors,” she says.

“Many are choosing to conduct face-to-face interviews, not only focusing on the fund manager and its operations but all the fund’s service providers including the administrators, directors and legal counsel. Funds are finding they need to deploy more resources to satisfying due diligence requests,” reveals Griffiths.

In the Mauritius office Craig Fulton notes that the approach to due diligence has been changing for quite some time. “There has been a growing trend towards greater legal due diligence over the last three to four years and with the recent financial crisis it is anticipated that this trend will only increase,” he notes. 

“Too often investors invested into funds without really understanding the impact of the fund’s constitutional documentation. Going forward, investors are going to want a much clearer understanding of the documents and the impact of these documents when the fund runs into difficulties,” he concludes.

Mitch Nichter at law firm Paul Hastings in New York believes investors, and particularly institutional investors, have significantly tightened their diligence activities. “One result of this tightening is that managers will need to invest more in compliance and risk management and be able to prove to investors and regulators that these are important integral components of the investment products offered,” suggests Nichter.