Why Most Hedge Fund Due Diligence Is Backwards
The industry does DD in the wrong order, focusing on returns before understanding the risk engine that produced them.
The standard hedge fund due diligence process is designed to be impressed. It is not designed to find the truth.
Most allocators walk into a manager meeting already half-convinced by a strong track record. The rest of the meeting is confirmation bias dressed as analysis.
The Wrong Order
Standard process:
- Review returns
- Meet the portfolio manager
- Evaluate the team and process
- Check operational infrastructure
- Decide
The problem is step one. By the time you’ve seen a strong return series, you’re emotionally anchored. Everything that follows gets interpreted through that lens.
Start With The Risk Engine
The right question is not “what returns did they make?” It is “how were these returns generated, and could that process have produced very different outcomes under different conditions?”
This requires understanding:
- The actual source of returns — carry, volatility, beta, true alpha
- The conditions required for the strategy to work — regime dependency is real
- The loss scenarios that exist but haven’t occurred yet
A 7-year track record through 2022 tells you something. It tells you very little about what happens in a credit crunch, a liquidity crisis, or a regime shift that the manager has never navigated.
Red Flags That Get Rationalised
Smooth return streams — real markets are volatile. Suspiciously smooth monthly returns deserve serious scrutiny, not admiration.
High Sharpe in illiquid strategies — illiquidity is a risk. If it’s not showing up in volatility, it’s being obscured somewhere.
The “we’ve never had a down year” manager — luck exists. A manager who has never had a down year is either exceptional or hasn’t yet been tested.
GP commitment hedged differently than the fund — if they’re running a different book with their own money, ask why.
What Operational DD Actually Means
Most allocators treat operational due diligence as a compliance exercise. It isn’t. Operational failures have caused more losses than strategy failures.
Focus on:
- Custody and counterparty arrangements
- Valuation independence and NAV verification
- Key person risk and succession
- Technology and data infrastructure — increasingly important
The Closing Question
After all the analysis, the most important question is the simplest:
If this strategy stops working tomorrow — for any reason — what is my exit, and at what cost?
If you can’t answer that clearly before you invest, you haven’t finished your work.