Preparing for the Family Office Due Diligence Process

Preparing for the Family Office Due Diligence Process

The due diligence process allows emerging hedge fund managers to demonstrate their fund's viability, strategy edge, and operational and compliance processes. Due diligence encompasses a broad spectrum of evaluations - from quantitative performance analysis to qualitative fund management and investment philosophy assessments.

Strategic and Performance Analysis

The cornerstone of any hedge fund is its investment strategy. Emerging managers must articulate their strategy, detailing a robust framework for generating returns while mitigating risks. This includes explaining the fund's edge over competitors, historical performance data, and the potential for strong returns in the future. Beyond performance metrics, investors are keenly interested in the strategy's scalability and adaptability to market changes.

What distinguishes your investment strategy from competitors? This question seeks clarity on the fund's unique value proposition and competitive edge. It also seeks to understand how your background is a unique fit for the strategy compared to other fund managers.

Can you detail your historical performance and provide context for these results? Understanding past performance, though not indicative of future results, gives insight into the fund’s capabilities. Questions around drawdowns, negative performance, and portfolio concentration will generally be discussed.

How do you ensure the scalability of your investment strategy? This examines the fund's potential for growth and adaptability under varying market conditions. It also gives the capital provider an idea of the capacity constraints for your strategy. We prefer niche and capacity-constrained strategies.

Operational Due Diligence

Operational integrity is paramount for family offices and institutions. Investors must assess the fund's infrastructure, evaluating the robustness of its administrative, compliance, and reporting systems. 

How is your fund structured regarding administration, compliance, and reporting? This question probes the robustness of the fund's operational infrastructure. This helps to ensure prompt and accurate reporting for the potential capital provider and lowers the event risk associated with the emerging manager.

What third-party service providers (administrators, auditors, etc.) do you engage with, and why? Emerging managers must demonstrate a commitment to transparency and operational efficiency with well-established fund administration, auditing, and risk management procedures. The presence of a reliable third-party administrator and a reputable auditor bodes well in this assessment.

Risk Management

The ability to navigate market volatilities and protect capital underpins investor confidence. Emerging hedge fund managers should elucidate their risk management framework, detailing how they identify, measure, and mitigate various risk types. 

Describe your risk management framework. How do you identify and mitigate risks? Effective risk management is vital for fund sustainability and investor confidence. This entails discussing leverage limits, evaluating the use of options or derivatives, stress testing, and downside risk analysis. Effective risk management strategies reassure investors of the fund's longevity and resilience.

What is your approach to leveraging and position sizing? This evaluates the fund's strategy for managing exposure and minimizing potential losses. This will also assess any position-level or industry-level constraints the manager has in place, along with the capital efficiency of the strategy.

Team Evaluation

Investors want to understand the experience and cohesion of the fund's management team. Diverse backgrounds in the strategy or asset class, and industry-specific knowledge are favorable. The team's collective track record, alignment of interests through personal investments in the fund, and the clarity of roles and responsibilities are critical elements of this evaluation.

Can you provide details on the experience and background of your management and operational team? The team's strength and compatibility are critical to executing the fund’s strategy. We like teams that have worked together at prior firms or have known each other for a long time.

How are your team's interests aligned with those of your investors? This question seeks to uncover the team’s investment in the fund and analyze the fee structure and carried interest. 

Can you provide examples of how you’ve navigated challenging market conditions in the past? This gives insight into the fund’s resilience and adaptability. We always like to ask about the worst trades a manager has made to see what they've learned from a risk management or discipline perspective.

Navigating the Due Diligence Process

The due diligence process for emerging fund managers is the gateway to securing seed capital from family offices and institutional investors. It allows managers to showcase their fund’s performance, strategic edge, and operational excellence. Emerging managers can navigate this path by preparing for each facet of due diligence—from strategic analysis and operations to risk management, compliance, and team evaluation.