As of late, there have been quite a few reports of large private investment limited partnerships (i.e., hedge funds) which have defrauded its investors of millions of dollars. The defrauded investors (i.e., limited partners of a renegade hedge fund) include high net worth (and supposedly sophisticated) investors as well as funds of hedge funds (which, by their very nature, should be managed by sophisticated and savvy managers). Yet, these very investors (who are supposed to be sophisticated enough that the government and the SEC afford less protection and oversight) have not been keen enough to notice (or inquire) into certain signs or warning signals that could help an investor to steer clear of making an investment in a hedge fund that is fraudulent. Remember that while hedge funds are by-and-large fairly private and secretive, as a prospective investor the investor can demand that it be permitted to conduct the due diligence it requires to be comfortable in making (and maintaining) an investment. Such due diligence should include looking for warning signs and making inquires about the prospective hedge fund and its manager, including the following:
Insisting on seeing the certified audited financials for at least the three most previous years for the hedge fund, if the fund has a track record;
Investigating the hedge fund, its manager entity and each of the individuals associated with the manager. At a minimum check the Securities and Exchange Commission, the National Association of Securities Dealers and the Commodity Futures Trading Commission. Also, do a simple Google check. Additionally, you may want to pay an investigative service to do research and background checks on these entities/persons; when you consider how much you may be investing in the hedge fund, such an expense for research may be well worth it;
Getting referrals from the managers of the hedge fund and check them;
Watching out for conflicts of interest, particularly if the hedge fund uses an affiliated broker dealer or the audit firm the hedge fund uses is affiliated in any way with the fund. Also, insist that an independent outside administrator be used;
Confirming that the pricing mechanism of the securities held by hedge fund are industry standard and be concerned if the manager of the hedge fund has carte blanche to determine the net asset value of the securities holdings;
Determining if the hedge fund allows certain of its securities positions to be separately accounted, because this may be a way for the hedge fund to report overall performance numbers that may not include separately accounted for securities that are doing very poorly;
Considering only investing in a hedge fund whose manager (or sub-advisor or the parent of the manager entity) is registered as investment adviser with the SEC (or the state equivalent) and who treats the hedge fund as a client for purposes of the investment advisers act. With the onset of the new SEC rule requiring many hedge fund managers to register as an investment adviser, this precaution may not limit the hedge fund universe as much as one might expect;
Considering a face to face visit with the hedge fund managers; and
While the above advice applies surely to making the initial decision to invest in a hedge fund, also consider doing many of the aforementioned tasks annually.
Even if an investor does everything possible and completes an intensive due diligence, there is simply no way to guarantee that the manager of a hedge fund does not intend to defraud the investor. However, by following the above due diligence (and taking other precautions that the investor or its advisers may determine) the investor should be able to substantially reduce the risk that the hedge fund it is investing in will abscond with the investor’s money.